Imagine you’re the portfolio manager for the SPDR Bloomberg Barclays Agg ETF (BNDS). Your portfolio holds 3,248 bonds at last count. Each day, you have to figure out what new bonds you actually want if an authorized participant shows up with an order for 100,000 new shares (worth about $5.6 million).

You certainly aren’t going to ask the AP to buy miniscule lots of 3,248 bonds, so instead you come up with a basket that broadly represents the exposure you need to keep the characteristics of the fund intact. As I write this, that’s still a huge list: 1,744 individual bonds, and then $436,1060 in cash that State Street will use to round out what the AP won’t deliver.

That list of 1,744 bonds goes out to all the APs first thing in the morning and they monitor that basket, knowing they can use it to make new shares. They’ll do their job, looking for a price discrepancy between how much the basket will cost them to buy, and how much the ETF is actually trading at.

Any time it looks like they could simultaneously buy all the bonds and sell the ETF shares for a profit, bingo, they pull the trigger. State Street and Bloomberg created a slick, mostly automated way of doing all this back in 2014 called “BSKT.”

The Problem

But trading bonds is hard. Now imagine there’s an AP with a small bond desk, and the AP looks at that list, and there’s some piece they just don’t think they can get easily, say, the 971 bonds from Consumers Energy in today’s basket. But the AP happens to have a whole pile of Southwestern Energy Bonds, which is also in the index, but isn’t on the list.

So, the AP calls you and says, “Hey, Bob, can you take this instead of what you asked for?” and a negotiation happens. In the end, you might say yes, or you might say, “You can send me more cash and I’ll just go buy them myself.” It works, but it’s a big, human, sloppy negotiation that both slows down the process and is rife with information gaps.